Do investors fully understand the economic implications of cash flows from operations

... ission of the copyright owner Further reproduction prohibited without permission ABSTRACT Do Investors Fully Understand the Economic Implications of Cash Flows from Operations? by Mei Luo Doctor... reporting them as part of operating cash flows or financing cash flows If the same cash effects are not classified in cash from operating activities’ but in other sections of the statement of cash flows, ... eproduced with perm ission of the copyright owner Further reproduction prohibited without permission Do Investors Fully Understand the Economic Implications of Cash Flows from Operations? Copyright

Do Investors Fully Understand the Economic Implications of Cash Flows from Operations? by Mei Luo B.ECON. (Tsinghua University) 1998 M.S. (University o f California, Berkeley) 2002 A dissertation submitted in partial satisfaction o f the requirements for the degree o f Doctor o f Philosophy in Business Administration in the GRADUATE DIVISION o f the UNIVERSITY OF CALIFORNIA, B E R K E L E Y Committee in charge: Professor Xiao-Jun Zhang, Chair Professor Sunil Dutta Professor Daniel L. McFadden Professor M aria Nondorf F a ll 2004 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3165474 Copyright 2004 by Luo, Mei All rights reserved. INFORMATION TO USERS The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleed-through, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. UMI UMI Microform 3165474 Copyright 2005 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. Do Investors Fully Understand the Economic Implications of Cash Flows from Operations? Copyright © 2004 by Mei Luo R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. ABSTRACT Do Investors Fully Understand the Economic Implications of Cash Flows from Operations? by Mei Luo Doctor o f Philosophy in Business Administration University o f California, Berkeley Professor Xiao-Jun Zhang, Chair This dissertation investigates the forecasting ability and persistence with respect to future cash flows o f four cash components, the inclusion o f which with Cash Flows from Operating Activities have the potential to generate misleading signals about the company’s financial picture. It also examines whether market participants fully reflect the cash components’ respective implications for future cash flows. Current operating cash flows play an important role in assessing future economic conditions and security values. The GAAP-based rules or flexibility faced by managements for reporting operating cash flows can potentially mislead investors in their assessments. Four components of operating cash flows are collected from fiscal years 1988-2000 for firms in the Fortune 1 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. 500 index as o f 2001: (1) nonrecuning cash flows, (2) tax benefits realized from nonqualified employee stock options, (3) investment-type cash outflows - R&D expenses and cash outlays involved in restructuring activities, and (4) cash proceeds from selling or securitizing accounts receivables. The dissertation documents that these operating cash components possess incremental value in predicting future cash flows over total operating cash flows and accrual components. They also differ in persistence from other operating cash flows coming from companies’ core and continuing operations. Furthermore, hedge portfolios using the information in tax benefits realized prior to the year 1999, research and development expenses and transactions o f selling or securitizing accounts receivables can separately earn positive abnormal returns over the subsequent six months up to three years. Their return predictive abilities persist after controlling for factors previously documented to predict returns. The empirical findings indicate that the stock market may not fully appreciate future economic implications o f components of current operating cash flows. Further analysis verifies that the market mispricing is partially due to failures to fully impound the future cash flow information (not necessarily future earnings information) contained in the operating cash flow components. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. This dissertation is dedicated to my parents: Luo Wanxin W 7 I M and Yu Dan ^ for their eternal love and faith in me, to my husband Zheng Yi ^ for his indispensable encouragement and support, and my sister Luo Yan ^ ffe for her company. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS 1. Introduction........................................................................................ 1 2. Motivation and Hypotheses 3. Research Methodology.......................... 3.1 ..... 17 3.1.1 Forecasting Im p licatio n s ............................ 3.L2 Persistence of C u rre n t Cash C om ponents........................... 17 21 3.2 22 Tests of Hypothesis I I ........................ 3.3 ............... ............................ 3.3.1 3.3.2 26 Persistence of the Cash C om ponents for F u tu re E a rn in g s ..................26 A bnorm al R eturns Associated w ith F u tu re C ash N ews....................... 26 Data and Sam ples 4.1 4.2 22 23 F u tu re E arnings Im plications V ersus F u tu re C ash Flow Implications.. ...... 5. 17 Test of Hypotheses H I (1) - H I (4)............................ 3.2.1 Portfolio A nalysis 3.2.2 Regression A nalyses 4. 9 ............ 29 Sam ple Selection and D escriptive Statistics ............. ........... ................... 29 D ata Collection P rocedures................. ................................. .......... ......... . 31 Empirical Results. 35 5.1 35 F u tu re Cash Flow Im p licatio n s...................... ii R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. 5.2 R esults of Hypothesis H I I ........................... 53 F u tu re E arnings Implications V ersus Future C ash Flow Im plications ............................. 37 Bisciissions and Sensitivity Analyses 43 ........ 41 6.1 A bnorm al R etu rn s A ssociated W ith Tax Benefits From Stock O ptions ................. .............4 3 6.2 Sensitivity Analyses.................................. 44 7. Conclusions and Implications.......................................................... 46 References............................ 48 Appendixes.......................................... 51 Figures............................... 59 Tables........................................................................................................... 63 m R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS I would like to than my dissertation chair Xiao-Jun Zhang, for his continual encouragement and invaluable guidance that is indispensable for the development and completion o f this work, the dissertation committee members Daniel L. McFadden and Maria Nondorf, for many great comments and suggestions, and especially to committee member Sunil Dutta for his support and mentoring to my endeavors pursuing the academic career. I have benefited greatly from discussions with William Beaver, Qintao Fan, Dwight Jaffee, Brett Trueman, and workshop participants at University of California, Berkeley and Stanford University. The generous help from my fellow doctoral students is gratefully acknowledged. Special thanks are due to Donglin Li, Haifeng You and Katherine Gunny. I would also like to thank Qing Yang, Jinwen Xiao, Jennie Jiang and Yan Liu, whose friendship made m y study at Berkeley enriching and enjoyable. Finally, thanks to warm-hearted dean Campbell, faculty and staff o f the Haas School o f Business for making my stay in Berkeley smooth. My greatest debt is to my parents, Yu Dan and Luo Wanxin, whose love and pride in me made the completion o f this degree possible. I am also indebted to m y husband, Yi Zheng, whose constant support, help and encouragement accompanied me through the whole process. I am grateful to my sister Luo Yan who grew up with me and helped me become the person I am today. IV R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. 1. Introduction The neo-classical equity valuation model well establishes that the equity value equals the discounted value o f expected future free cash flows. Three versions of the valuation approaches are commonly used: free cash flows model, dividends model, and earnings model. Under the premise that cash flow prediction is fundamental to assessing firm value, the investment community and academic research have studied the prediction o f future cash flows. The Financial Accounting Standards Board (FASB) also indicates that a primary objective o f financial reporting is to provide information to help investors, creditors and others assess the amount and timing o f prospective cash flows.' The ability o f current operating cash flows to predict firms’ future cash flow performance is evident in prior studies. The general conclusion is that earnings components - aggregate cash flows from operations and accruals, have significant predictive ability for future cash flows from operations, a component o f free cash flows (e.g., Dechow et al. 1998, Barth et al. 2001 and Finger 1994). Using share prices as an implicit proxy for expected future cash flows, studies have shown that current cash flows from operations has information content incremental to current earnings and accruals (e.g., Wilson 1986, 1987). These studies tend to treat each dollar o f current cash flows from operations as having the same persistence or the same predictive ability for future cash flows, ignoring the composition of the cash flows.^ FASB 1978, 37-39. ^In the presence of other explanatory variables that may capture information in the cash composition, the same predictive ability is still imposed on each dollar of cash after controlling for the other variables in predicting future cash flows. 1 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. “Cash is the King”, which has been proposed as the underlying valuation metric, and often times the closeness to cash figure is used to diagnose earnings quality. Operating cash flows particularly measure the firm’s ability to generate cash flows internally, and they can help investors gain important insights into a company’s core business, especially when the faith in earnings figures is shattered by many alleged accounting irregularities. However, the Wall Street Journal (C l, May 8, 2002) has one article illustrating how the sums o f cash flow reported in financial filings are less than they appear at first blush. “Long viewed as the most reliable, least manipulated o f the financial documents filed by a company, the ‘statement o f cash flows’ has its shortcomings, too... If you think operating cash flow as reported actually gives you operating cash flow, you are kidding yourself.” When certain cash flows are not generated by firms’ continuing and core operations, or are subject to management discretion or conditions beyond management’s control, they would behave differently from other operating cash flows in terms o f abilities to map into future cash flows. “The Financial Numbers Game” (Mulford and Comiskey 2002) lists various problems with the GAAP-based rules and flexibility faced by management for reporting operating cash flows. The inclusion o f cash effects whose recurrence is doubtful due to various economic characteristics can potentially generate misleading signals about the company’s cash generating power if investors fixate on the face value of reported operating cash flow. Among the transactions causing concerns to investors and academics are the following cash events: ( 1) nonrecurring cash flows, (2) tax benefits realized from the exercise of nonqualified employee stock options,^ (3) investment-type ^The Emerging Issues Task Force (EITF) Issue 00-15 requires the income tax benefits due to stock options be classified as an operating cash flow in the cash flow statement, effective for financial statements after 2 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. cash outflows - R&D expenses and cash outlays involved in restructuring activities, and (4) cash proceeds from selling or securitizing accounts receivable.'^ To what extent investors distinguish among various cash flow components and unravel the additional information contained in reported current operating cash flows about future cash flows remains an interesting question. This dissertation investigates the future economic implications o f these four components o f operating cash flows that may behave differently from other core and continuing operating cash flows and have the potential to generate misleading signals. It also examines whether market participants fully incorporate the information contained in these components. I perform the analyses on firms in the Fortune 500 index as o f year 2001. The sample period spans 13 years from 1988 to 2000. Heavy scrutiny focused on mature and large firms ensures cash flow statements are an important piece o f information used to assess future prospects. I first investigate the future cash flow implications, i.e., forecasting abilities and persistence, o f each o f the four identified cash components. Empirically shown to possess superior cash forecasting ability, the cash forecast model in Barth, Cram and Nelson (2001) documents the significant predictive ability o f total operating cash flow and accruals. Therefore, I test the incremental predictive ability o f each cash component controlling for the free cash flow (operating cash flow minus capital expenditures) and accrual components. The results show that the four cash flow components differ in July 20, 2000. Prior to the effective date, companies have choice of reporting them as part of operating cash flows or financing cash flows. If the same cash effects are not classified in ‘cash from operating activities’ but in other sections of the statement of cash flows, this study does not deem it as problematic operating cash reporting, and those firms would have zero of such operating cash components. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. persistence from the other operating cash flows^ and possess significant incremental value in the prediction o f cash flows in the next three years (both operating cash flows and free cash flows). Speciflcally, nonrecurring cash flows lead to relatively fewer future cash flows and they are relevant for forecasting cash flows o f the following two years, in contrast with the nonrecurring (transitory) items called by the companies. Tax benefits realized prior to 1999 from employee stock option exercises are a strong positive indicator o f future cash flows, but the benefits realized thereafter are less persistent and even capture negative news about multiple-year-ahead cash flows. Research and development cash investment outflows (measured as negative cash flows) have a lower coefficient in predicting long-term cash flows, possibly due to offsetting of positive cash benefits with the persistent investment cash outflows. Contrary to investors’ concerns, the cash effects o f selling or securitizing accounts receivable that are subject to managerial discretion, tend to have the same likelihood o f recurrence as other operating cash flows. However, firms engaging in these inherently financing transactions will systematically experience lower cash flows in the following three years than firms not using the financing vehicle, implying that firms can boost current cash flows by sacrificing future cash flows. I investigate whether stock prices fully incorporate the components’ respective implications for future cash flows by performing portfolio return analyses over the three years subsequent to financial statement releases and conducting cross-sectional regressions o f future retums on the cash flow components. The results indicate that hedge portfolios exploiting the information in tax benefits o f stock options prior to 1999, R&D ^The other operating cash flows generally include operating cash flows from core and continuing operations, the difference between total operating cash flows and each of the cash components o f interest identified in this study. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. expense, or transactions of selling or securitizing part o f accounts receivables can separately earn positive abnormal retums over the subsequent one-year, each o f the three years, or six months. The cash transactions’ associations with future abnormal retums are consistent with their incremental implications for future cash flows and are robust to the inclusion of previously documented retum predictors. The cash components also fully capture the retum predictive ability o f the accmal anomaly first found in Sloan (1996). The reverse relation between tax benefits realized after 1998 and future retums seems to reflect risk changes correlated with factors documented in prior studies or the wealth transfer effects o f the stock options. Additionally, the stock market fully reflects the additional information in nonrecurring cash flows. This dissertation focuses on the prediction o f future cash flows, a theoretical valuation input, to test whether the stock market correctly reflects the cash flow components’ implications for future cash flows. There is a body o f literature on m arket’s naive expectations about future eamings, with the underlying premise that earnings are used in assessing equity values. Penman and Zhang (2002) suggest investors fixate on eamings and fail to differentiate eamings quality due to conservative accounting, and Sloan (1996) shows that stock retums do not fully reflect information about future eamings contained in the accrual and cash flow components.® In a supplementary test, I examine the eamings implications o f the four cash flow components. Except that tax benefits o f stock options have a strong negative effect on eamings persistence for the whole sample period, the other cash flow components consistently have the same directional impact on future eamings as on future cash flows. To verify that the market * Some of the other studies that relate market efficiency to the understanding of certain variables’ implications for future eamings include Beaver et al. (2001), Xie (2001), and Rajgopal et al. (2003). 5 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. mispricing is at least partially attributable to failures to fully impound future cash flow implications, I decompose the subsequent year abnormal retums into the component arising from one-year-ahead cash flow news and the component associated with other factors, including eamings news. The results are consistent with price corrections in response to the one-year-ahead cash flow news that are predictable from the various cash components. I also find that the cash news-related abnormal retums are significantly associated with R&D, tax benefits o f stock options realized prior to 1999 and selling or securitizing accounts receivable, in the direction consistent with their future cash flow implications. The significant abnormal retums over multiple future years predictable by R&D expenses indicate that price corrections are incomplete as to the realization of short-term cash flows. However, I do not exclude the possibility that some unknown risk factor not reflected in factors suggested by Fama and French (1992) accounts for the persistent significant retums. My study makes the following contributions. Foremost, this dissertation contributes to the literature on forecasting cash flows. Until recently, this literature has largely focused on comparing the ability o f eamings and operating cash flows to predict future cash flows. Dechow, Kothari and Watts (1998) and Barth et al. (2001) find the accraal components enhance the predictive ability. M y study constitutes an attempt to investigate the incremental predictive value o f selected components o f operating cash flows over accraals and aggregate operating cash flows. Second, it addresses public concerns that the reported operating cash flow from the statements o f cash flows can potentially mislead investors when the cash flow effects o f certain transactions are included. The large tax benefits realized from employee stock options in the period o f high-flying stock prices do R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. not sustain, but those realized prior to 1999 provide a positive signal about future cash flows. The common practice o f sale or securitization o f accounts receivables does not generate less persistent cash flows and it apparently sacrifices future cash flows while increasing current cash flows. Third, this dissertation adds to the market efficiency literature that investigates whether accounting information is fully impounded in stock prices. Different from most prior studies that assume investors fixate on eamings prediction, this study is conducted under the premise that investors also predict cash flows to assess firm value. Failing to fully impound the future cash flow information contained in the current statements will result in predictable abnormal retums. The results corroborate the notion that cash flow prediction is the ultimate fundamental valuation attribute. Prior studies have documented a significant relation between future abnormal retums and accmals (or total cash flows). While Desai, Rajgopal and Venkatachalam (2004) asserts that the accmal anomaly can be a manifestation o f the glamour stock phenomenon, my study potentially provides an altemative explanation in that the market fails to fully reflect the information in the various cash flow components. Finally, this study provides subtle implications for standard setting bodies about cash flow reporting and the disclosure o f cash effects from significant transactions. Investors as a whole do not appear to fully understand the implications o f certain cash flow components, possibly due to high costs (e.g., lack o f detailed disclosures or skill requirements) of analyzing the statement o f cash flows reported under the current disclosure regime. Prior studies have documented the widespread nonarticulation in the cash flow statements and listed some factors causing the nonarticuiated differences, e.g., Bahnson et al. (1996) and Drtina and Largay (1985).’ The results of this dissertation should also be o f interest to financial Under the indirect method of presenting the statement of operating cash flows, net income is adjusted by 7 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. statement users, such as asset managers, creditors, and analysts, who wish to understand cash flow reporting and cash forecasting. The remainder o f the dissertation is organized as follows. The next section provides motivation and hypotheses development. Section 3 explains the estimation models and research methodology. Section 4 describes the samples and data. Section 5 presents the results and section 6 provides further discussion and sensitivity analyses. Section 7 concludes the dissertation with implications for future research. changes in current accounts that would equal the differences between the beginning and ending balances on the balance sheet. This adjustment assumes that changes in a noncash current account relate an operating source or use of cash to an income statement account. When current accounts change without a link to the income statement, errors occur when mechanically applying the indirect method. For example, if stocks are issued to settle a significant portion of accounts payable, a nonarticulated difference occurs when net income is adjusted by changes in the balance of accounts payable that obviously are not related to income statement. R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. 2, Motivation and Hypotheses Prior studies have examined the role o f current aggregate cash flows and eamings in predicting future cash flows and report mixed results about their relative predictive ability (e.g., Bowen et al. 1986, Finger 1994, and Greenberg et al. 1986). Barth et al. (2001) extend prior work and find that eamings, when disaggregated into cash flows from operations and accmal components, perform better in predicting future cash flows than current and past cash flows or current and past aggregate eamings. Using stock prices as a measure o f information content, research has shown that the cash flow and accmal components o f eamings have incremental information content beyond eamings. Some examples are Wilson (1986, 1987), Bowen et al. (1987), and Raybum (1986). Other studies examine the association with contemporaneous security retums. Examples include Lipe (1986) on six eamings components, Barth et al. (1999) on accmals and cash flows, and Livnat and Zarowin (1990) on operating, financing and investing cash flows. The current aggregate operating cash flows have incremental value over eamings or accmals in predicting future cash flows and its incremental information content is reflected in stock values. Reported cash flows are generally regarded as being less subject to distortion than reported eamings. In recent years investors have seen outbreaks o f myriad alleged accounting irregularities, the proliferation o f pro-forma eamings and the SEC’s broadened investigations into accounting malpractices to boost eamings figures across a R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. broad range o f industries.® However, holding the cash flow statement as a beacon o f truth can also be imprudent. Due to different composition characteristics, the same amount of cash from operations may imply varying future cash prospects. Cash flows sustain only when the underlying operating activity is likely to recur. For example, if current cash flows comprise a large amount o f nonrecurring cash items, the current cash figure will not be a good indicator for next period’s cash flows. Some studies (e.g., Barth et al. 1999) find the cross-industry variation in the persistence parameter o f cash from operations, but they still impose restrictions on the components o f cash flows to have the same ability to forecast future cash flows. Taking the reported cash flows at face value forsakes information contained in the components that is relevant for predicting future cash flows. Several operating cash components may inform about future cash flows differently from the other operating cash flows. By definition, nonrecurring cash items, ex-ante, are not expected to recur in the future in the same way as other routinely generated cash. Operating cash flows include some investment-type expenditures such as R&D expenses that are expected to generate cash flows over multiple future periods. The lack of matching between the cash costs o f the investments and their benefits can result in a different predictive ability from other periodic cash outflows. The cash flow effects from some significant special transactions can be either subject to managerial discretion or to conditions not directly controlled by management. The items emphasized by Mulford and Comiskey (2002) and the previously cited WSJ article are the tax benefits from the * Among the investigations by SEC into the false accounting practices are Enron Corp. ’s various wrongdoings, Adelphia Communications Corp.’s participation in related party transactions (WSJ, May 17, 2002), illusory “round-trip” trades to boost revenues by energy-trading companies like Dynegy Inc., Reliant Resources Inc. and CMS Energy Coip. (WSJ, May 16, 2002), and Computer Associates International Inc.’s aggressive revenue-recognition policies and practices (WSJ, May 16, 2002). 10 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. exercise o f employee stock options (when reported as part o f operating cash flow) and cash proceeds from sale or securitization o f accounts receivable. The following paragraphs provide the reasoning to examine the potential incremental information contained in these four cash categories and develop the first hypothesis regarding their forecasting abilities and persistence.® Nonrecurring cash flows: Under the indirect method o f preparing the statement o f cash flows from operating activities, the starting point is the net income. Included in net income are several nonrecurring items such as Income from Discontinued Operations and Extraordinary Items, Cumulative Effects o f Change in Accounting Principle, special items like asset w rite -o ffs a n d others. The associated cash effects o f these unusual or infrequent income components may possess less predictive ability for future cash flows than the other cash flows. One example is cash from the operating income or loss o f discontinued operations. If these items are really nonrecurring as claimed by companies in the financial statements, they should be irrelevant for forecasting future cash flows.” However, firms have started to include more items in the special item or nonrecurring ®This is not to claim the rest of the cash flow components do not provide incremental information about future cash flows. Rather, I analyze the cash components that have caught the attention of investors and academia but have not been formally examined. These cash flow items are also available by inexpensive and skillful search in companies’ financial statements. Extracting every interesting cash flow item would incur high costs due to nonarticulation in the operating cash flow statement under the indirect method. Some other components, such as interest expense, are debated on the reasonableness to be classified as operating cash flows, which is beyond the scope of this study. This dissertation analyzes the operating cash components based on the sample-year’s effective format and classifications of cash flows. See “Nonrecurring items...” Financial Statement Analysis, 7* Edition, Wild, Bernstein and Subramanyam (2001, P417). " Ohlson (1999) uses the term “forecasting irrelevancy” to label the condition that transitory eamings items are forecasting irrelevant for next period’s abnormal eamings. Nonrecurring (or transitory) cash flows are interpreted here as forecasting irrelevant with respect to future cash flows. 11 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. category. Gu and Chen (2003) find that both o f the ‘nonrecurring items’ analysts decide to keep in and exclude from reported street eamings are significantly associated with future performance. The cash effects involved in the nonrecurring items may well be relevant in forecasting future cash flows. The altemative hypothesis regarding nonrecurring cash flows follows: H I (1): Cash flows claimed to he nonrecurring by companies are less recurring than other operating cash flows and are relevant in forecasting future cash flows (i.e., not nonrecurring). Tax benefits from employee stock options: When nonqualified employee stock options are exercised, the issuing company will receive a tax benefit that equals the tax rate times the difference between the exercise price and market price on the date options are exercised. I refer to the reduction in taxes payable from this transaction as the tax benefits from employee stock options. In 2000, the EITF reached a consensus and decided that such tax benefits should be included with operating cash flows. This treatment is viewed as somewhat problematic cash flow reporting (Penman 2002) because there is no recognition o f the matching option expenses that produced the tax benefits. In the market boom period, option exercises have created large corporate tax This tax treatment applies in situations when options do not have a readily ascertainable fair market value at the date of grant. Most companies that issue nonqualified stock options do not have options with a readily ascertainable fair market value. If the options are considered subject to substantial risk of forfeiture, the issuing company may not receive the tax benefit at the date of exercise, rather when restrictions on the options lapse, depending on the employee’s choice o f income recognition date (correspondingly, the entitled compensation deduction is the difference between market price of the stock on the date the restrictions lapse and the exercise price). See more details in “Concepts in Federal Taxation”, Murphy & Higgins (p. 655), 2003 edition. 12 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. deductions and boosted operating cash flows, while in the recent recession period, not as many benefits have accrued to those firms because o f falling stock prices. The tax benefits are mostly influenced by employee exercise decisions and market factors, and thus are outside o f the corporation’s direct control. The cash savings are likely to be more transitory than other operating cash flows, and less related to the core operations o f the firm. However, large employee option exercises induced by good market conditions may reflect the strong underlying operations that can persist promisingly into future periods. The likelihood o f recurrence o f tax benefits from stock options is ambiguous; however, the high levels observed during the market boom period are less likely to represent recurring cash flows. Stated formally; HI (2): Tax benefits from exercising non-qualified employee stock options differ from other operating cash flows in their likelihood o f recurrence and the benefits realized in the market boom period are less likely to recur than those realized in the prior period. Cash expenses related to investing activities: Investment costs that are expensed as incurred in the income statement are treated as uses o f cash in the operating section o f the statement of cash flows. Two items o f interest are research and development costs and cash expenses involved with restructuring charges. Expensing research and development costs is criticized in some academic research for the mismatching o f costs and related future revenues. Lev and Sougiannis (1996) show that the R&D capitalization process Ciprianao, Collins and Hribar (2001) report that the tax savings from employee stock option deductions for the S&P 100 and the Nasdaq 100 averaged 32 percent of operating cash flows in 2000, up from 8 percent in 1997. 13 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. yields value-relevant information to investors. Penman and Zhang (2002) show that R&D expensing reflects a conservative accounting process that makes the eamings less o f an indicator for future eamings. Furthermore, restmcturing charges (sometimes reported as part o f special items) are typically investments to streamline a company’s operations for improving future profitability.''^ They usually impact several future years and involve substantial cash flow commitments that are included with operating cash flows. Including these cash investments can skew the reported cash from operations downward. Some high-growth firms may not generate positive operating cash flows in the current period as a result o f heavy investments, however they may have tremendous cash inflows when those investments tum out to be successful. The ability o f these investment-type cash expenditures to indicate future cash flows probably differs from that o f periodic operating cash expenses that typically do not bring future benefits. H I (3): Investment-type expenditures included with operating cash flows have a different ability to predict future cash flows from other periodic operating cash expenses. Cash proceeds from sale or securitization o f accounts receivable: Decreases in the balances o f operating-related assets are added when reconciling net income to cash flow from operating activities. Management can exercise discretion to decrease accounts receivable by securitizing or selling accounts receivable, which would temporarily boost current operating cash flow at the expense o f future cash flows. If the amounts involved are significant, the financial health o f the firm will be distorted. The Wall Street Journal Carter (2000) presents some evidence of operating performance improvement in the long run following a restmcturing. 14 Reproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. (May 8 , 2002, C3) illustrated that TRW Inc.’s eamings dropped to $ 6 8 million in 2001 from $438 million one year ago, but operating cash flow rose to $1.49 billion from $1.15 billion largely due to the $327 million received from accounts receivable securitization. W ith selling or securitizating accounts receivable, firms discount all future cash inflows into present, mechanically resulting in lower cash inflows in the future periods than everything-else-equal firms. The cash effects o f such significant isolated events may not recur because they are subject to managerial discretion. Nonetheless, the accounts receivables sold or financed are generated from the continuing and core operating activities. Therefore, if firms engage in these transactions regularly, the cash effects could be recurring. The hypothesis regarding the persistence o f these cash flows is stated in altemative form: HI (4): The cash flow effects from the sale or securitization o f accounts receivable are less recurring than other operating cash flows. The second hypothesis concems the extent to which stock prices distinguish among various cash components and reflect their respective forecasting and persistence properties for future cash flows. If the cash components are not priced in a manner consistent with their respective cash flow implications, as new information about future cash flows arrives or actual cash flows are revealed, subsequent stock prices will gradually reflect the information and predictable abnormal retums will occur. HII: Stock prices fail to fully reflect the information contained in the four identified cash components at the time o f financial statement release. Firms reporting relatively high levels o f cash components providing positive 15 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. information and firms reporting relatively low levels o f cash components providing negative information will experience a higher abnormal return in the subsequent periods. 16 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. 3. Research Methodology 3.1 3.1.1 T est of Hypotheses H I (1) - H I (4) Forecasting Im plications Building on the Dechow, Kothari and Watts (1998) model o f the accrual process to predict future operating cash flows, Barth, Cram and Nelson (2001) find that each major accrual component - change in accounts receivable, change in accounts payable, change in inventory, depreciation and amortization, and other accruals, reflect different information relating to future cash flows, incremental to current total cash flows. Disaggregating earnings into current aggregate operating cash flows and accrual components substantially enhances the predictive ability. Appendix A details the model developed in Dechow et al. (1998) and Barth et al. (2001). I investigate the prediction o f two definitions o f future cash flows CF; operating cash flows (OCF) as used in previously studied cash forecasting models, and free cash flows (FCF) considered as the fundamental valuation inputs. In testing the incremental predictive ability o f each current cash flow component separately, I control for the accrual components as well as current free cash flows (OCF minus capital expenditures) as opposed to operating cash flow (OCF) in Barth et al. (2001), and allow different coefficients on OCF and capital expenditures.^^ It is uncertain when the future cash flows predictable by the various cash This benchmark cash forecast model is relatively more restrictive in testing the differential implications of cash components, because the incremental information in cash components about future cash flows will be mitigated to the extent that the accrual components or capital expenditures are correlated with cash components. For example, the change in accounts receivable is highly correlated with cash proceeds received from accounts receivable sale or securitization. Alternatively, a more relaxed cash forecast model using total accruals and operating cash flows is employed as the basic benchmark model for comparative purposes: Future Cash Flows = a + piOCF + P7total accruals + Scash component + s. The results (not reported) indicate the information properties of each of the cash components are not sensitive to the choice between the two models. 17 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. components will arise, so one-year, two-year and three-year ahead cash flows are placed as the dependent variable. Following Barth et al. (2001), I deflated all variables by average total assets. The firm-specific subscript i is omitted. The first estimation equation provides a basis for comparison with prior research and testing the hypotheses regarding the incremental predictive ability o f each current cash component. C F , . n = a + ydi X O C F , + p i x C A P I T A L , + J3 3 x A A R . + J3 4 x A I N V , + p 5 X A A P , + p e x D E P A M O , + /? 7 x O A C C , + £, 4 n Where n=l,2 and 3. CFt+n = future one year, two-year, three-year ahead cash flow from operations (OCF) or free cash flows (FCF). OCFt = total cash flow from operations measured at the fiscal year-end t. CAPITALt = total capital expenditures in fiscal year t (FCF-OCF-CAPITAL). The accrual variables are defined the same as in Barth et al. (2001): AARt, change in accounts receivable, AINVt, change in inventory, AAPt, change in accounts payable, DEPAMOt, depreciation and amortization expenses, and GACCt, the other accruals that are calculated as EAR (earnings) minus (OCF+AAR+AINV-AAP-DEPAMO). The first sub-hypothesis is tested via a pooled regression o f the following model. C F , . . = a + / F x OCF , + p i x CAPI TAL, + S i x N O N R E C , + f } 3 x A A R , + /?4X AI NV, + P s x A A P , + p9000 and S '2 , §2 f te s t' (p - v a lu e ) P ,+ 8 ,= 0 >S"2 (0 .0 0 ) ( 0 J 5 ) , (0 .0 0 ) 69 Reproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. TABLE 6 (Continued) Panel B: Pooled Regressions Using Two-Year and Three-Year-Ahead Cash Flows (n = 2,3)‘’’‘^ D ependant Variable - CFt+3 D ependant Variable - CFt+2 (I) (II) (III) R&D NONREC (IV) Y' xTAXBEN Y" xTAXBEN (II) (III) R&D RESTR (IV) RESTR -0.481 -0.407 (0.00) YxTAXBEN (I) (0.00) 0.969 0.816 (0.00) (0.00) -0.408 (0.47) -0.362 (0.27) -0.737 (0.16) N/A -0,178 RD -0.204 (0.00) RESTR (0.00) -0.395 (0.11) ARFINxDUM -0.464 (0.02) -0.054 (0.51) -0.09 (0.20) -0.01 DUM -0.008 (0.03) (0.00) Adj. R2 te st" (p-value) 35% 35% 35% 35% 35% 30% 30% 31% 31% 30% Pi+5i=0 §2 > 8*2 (0.48) (0.00) Pl+5]=0 §2 > d'l 1 &2 >§^2 (0.04) (0.02), (0.00) “ Dependant variable is one-year-ahead operating cash flows. Alternatively, it is replaced with one-yearahead free cash flows, and results on the forecasting abilities of each cash component are qualitatively the same. The primary sample consists o f 3,172 annual firm-year observations during the period of 1988-2000. ’’ See variable definitions in Table 1. The numbers in parentheses below the coefficient estimates are twosided p-values associated with heteroscedasticity consistent White-t statistics. Numbers in bold indicate the significance level at or below 5% level, two-sided. ARFIN represents ARFIN l . Chi-squared statistics and p-values are based on the heteroscedasticity consistent covariance of estimates. They are reported for the tests of forecasting relevancy ofNONREC and tests of difference in coefficients on TAXBEN across three periods; pre-1999, fiscal year 1999 and fiscal year 2000. The year indicators Y equals 1 if in pre-1999, and 0 otherwise, Y' equals 1 if in 1999 and 0 otherwise, and Y" equals 1 if in 2000 and 0 otherwise. ‘‘ The estimates for terms related to INT, OCF, CAPITAL and five accraal components are suppressed. The sample consists of 3,152 and 2,866 firm-year observations from 1988-2000, in regressions using twoyear-ahead and three-year ahead operating cash flows, respectively. Using future free cash flows yield similar results. Observations o f fiscal year 2000 are not included in the sample in testing the three-year ahead cash flows, so the coefficient on Y"xTAXBEN is not applicable. 70 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. TABLE 7 Persistence of C u rre n t O perating C ash C om ponents fo r F u tu re O perating Cash Flows. Sam ple of 3,172 F irm -Y ear O bservations, 1988-2000 “ OCFt+„ = a + /9 ix OCFt + Stx NONREC + & x 7 x TAXBEN+ 5'i xY 'x TAXBEN, + 5 \ xY" x TAXBEN, + SixRDi+S'3xRESTR, + S4xA R F IN txD U M +S\D U M +£, +n (V) n = l, 2, and 3 Predicted Sign INT OCF NONREC - YxTAXBEN +/- Dependent Variables CFt+2 CFt+3 0.047 0.057 0.058 (0 .00) (0 .00) (0 .00) 0.542 0.450 0.428 (0 .00) (0 .00) (0 .00) -0.189 -0.305 -0.462 (0.05) (0.00) (0.00) 1.305 1.178 0.872 (0.00) (0.00) (0.01) CFt+] Y' xTAXBEN + /- 0.397 -0.486 -0.884 (0.16) (0.42) (0.09) Y"xTAXBEN +/- -0.229 -0.55 N/A (0.55) (0.10) -0.252 -0.293 -0.311 (0.00) (0.00) (0.00) RD + /- RESTR + /- ARFINxDUM - DUM - Adj. R2 test (p-value) 0.227 -0.002 -0.017 (0.24) (0.99) (0.94) -0.079 -0.133 -0.092 (0.43) (0 .10) (0.37) -0.014 -0.016 -0.013 (0.«0) (0 .00) (0.00) 42% 31% 29% §2 > §'2 , 82 >5"2 82 > 6 '2 ,S 2 > 8"2 82 > 8'2 (0.03), (0.00) (0 .01 ), (0 .00 ) (0 .00 ) “ The numbers in parentheses below the coefficient estimates are two-sided p-values associated with heteroscedasticity consistent White-t statistics and Chi-squared statistics. Numbers in bold indicate the significance level at or below 10% level, two-sided. ARFIN represents ARFIN_1. Observations of fiscal year 2000 are not included in the sample in testing the three-year ahead cash flows, so the coefficient on Y"xTAXBEN is not applicable. See variable definitions in Table 1. 71 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. CD ■D O Q. C o CD Q. ■CDD C/) W o' o TABLE 8 One-Year-Ahead Abnormal Returns to Hedge portfolios Taking Positions in the E xtrem e Top and Bottom Decile Portfolios, Based on Information in Each of the Cash Components - Full Sample * o o o Hedge Portfolio Returns - s iz e ■D c q YEAR ' im NONREC TAXBEN RD RESTR ARFIN DUM NONREC TAXBEN RD RESTR ARFIN DUM -0.208 0.245 0.003 -0.101 0.102 0.167 -0.180 0,250 0.021 -0.099 0.098 0.161 0.174 0.220 -0.121 0.359 0.316 -0.143 0.376 0.333 0.077 0.168 0.065 -0.186 -0.251 -0.071 0.009 0.164 0.053 -0.173 -0.262 0.227 -0.109 0.075 0.031 0.125 0.186 0.217 -0.116 0.072 0.030 -0.033 0.067 0.012 0.148 0.126 0.134 -0.026 0.069 0.018 0.260 0,033 -0.052 -0.018 0.040 0.106 0.278 0.031 -0.092 -0.041 0.175 -0.143 0.085 0.136 0.307 0.173 0.190 -0.130 0.080 0.137 0.231 -0.085 0.091 0.108 -0.026 0.344 0.259 -0.077 0.101 0.119 0.102 -0.096 0.086 -0.052 -0.133 0.066 0.102 -0.077 0.096 -0.054 -0.131 0.048 0,335 0.485 0.065 0.051 -0.044 0.049 0.356 0.562 0.075 -0.006 -0.039 1998 0.075 0.676 0.970 0.406 0.205 0.119 0.015 0.606 0.896 0.426 0.158 0.084 1999 0.164 -0.325 -0.319 -0.056 0.055 0.066 0.179 -0.342 -0.336 -0,068 0.049 0.058 2000 -0.077 -0.313 -0.330 -0.051 0.036 0.040 -0.015 -0.364 -0.375 -0.062 0.029 0.011 Mean 0.053 0.14 0.16 -0.005 0.066 0.044 0.055 0.13 0.17 -0.001 0.05 0.035 T-stat (1.44) (1.95)* (1.77)* (-0.125) (1.79)* (1.09) (1.63) (1.82)* (1.79)* (-0.04) (1.49) (0.90) 1989 O.OSO 1990 -0.084 0.019 1991 0.126 0.188 O’ o 1992 0.143 0.125 0.146 1993 0.040 0.105 CD 1994 0.332 0.172 1995 -0.014 0.339 1996 0.068 1997 ■D O Q . c a o Q ■O o CD Q . ■CDD C/) C/) -4 N Hedge Portfolio Returns - market adjusted a d ju s te d pre-1999 0.168 Mean: 0.22 T-stat: (4.2)*** 0.215 Mean: 0.22 T-stat: (4.5)*** “ The full-sample consists of 3,238 firm-year observations. The one-year-ahead abnormal return calculations on each component are restricted to firmyears with available data to estimate the corresponding basic cash forecast model explained in footnote 15. Hedge portfolio returns in each year are calculated as the abnormal return on the top decile minus the return on the bottom decile portfolios for TAXBEN, and returns on the bottom decile minus returns on the top decile portfolios for NONREC, RD, RESTR and ARFIN because these components have negative coefficients as provided in Table 6 . Both size-adjusted and market-adjusted abnormal returns are calculated for each firm in the portfolio beginning three months after fiscal year-end. **The returns under column ‘DUM’ are calculated as the abnormal returns o f firms with DUM=0 minus the returns of firms with DUM=1. ARFIN represents ARFIN 1. The t statistics are provided on the time-series means of 13 annual hedge portfolio returns, and also on the means o f 11 annual returns for years prior to 1999 for TAXBEN. ***, ♦*, and ♦ denote statistically significant at the 1%, 5%, and 10% levels, based on two-tailed t tests. CD ■D O Q. C o CD Q. ■CDD C/) W o' o TABLE 9 o One-Year-Ahead Abnormal Returns to Hedge Portfolios Taking Positions in the Top and Bottom Quartile Portfolios, Based on Information in Each of the Cash Components - Non-zero Observations *’ o o ■D c q Hedge Portfolio Returns - market adjusted Hedge Portfolio Returns - size adjusted ' NONREC TAXBEN RD RESTR ARFIN NONREC TAXBEN RD RESTR ARFIN 1988 -0.243 -0.189 -0.155 -0.172 -0.250 -0.204 -0.146 -0.153 -0.153 -0.154 0.060 YEAR O’ o CD ■D O Q . C a o Q ■o o CD Q . ■CDD (/) W oo' oJ I9S9 -0.022 0.246 0.192 0.033 0.086 -0.013 0.326 0.198 0.014 1990 -0.182 0.244 0.244 0.260 0.180 -0.151 0.210 0.257 0.263 0.226 1991 0.096 -0.213 0.245 0.084 0.053 0.104 -0.215 0.249 0,078 0.059 1992 0.061 0.108 0.295 -0.135 0.470 0.072 0.090 0.293 -0.140 0.446 1993 0,001 0.228 0.177 -0.011 -0.208 -0.001 0.234 0.160 -0.028 -0.271 1994 -0.123 0.365 0.264 -0.044 -0.207 -0.150 0.347 0.272 -0.043 -0.192 -0.010 -0.020 1995 -0.051 0.492 0.215 -0.060 -0.049 -0.059 0.509 0.225 -0.059 1996 0.104 0.153 -0.054 0.422 -0.031 0.101 0.155 -0.035 0.434 1997 0.063 0.356 0.518 0.332 -0.235 0.066 0.420 0,584 0.306 -0.324 0.849 0.263 -0.185 1998 0.071 0.958 0.912 0.324 -0.172 0.036 0.875 1999 0.126 -0.396 -0.315 -0.077 0.103 0.148 -0.426 -0.316 -0.086 0.082 2000 -0.037 -0.371 -0.144 -0.021 0.016 0.031 -0.413 -0.169 -0.026 0.023 Mean -0.01 0.15 0.18 0.07 -0.02 -0.002 0.15 0.19 0.06 -0.02 (-0.05) (1.46) (2.1)** (1.2) (-0.34) T-stat pre-1999 (-0.33) (1.46) Mean: 0.25 T-stat: (2.6)*** (2.1)** (1.32) (-0.33) Mean: 0.25 T-stat: (2.8)*** “ The sample contains primarily 1,635 firm-years with available market-adjusted return data. Only non-zero observations of each cash component are assigned into four equal-sized portfolios in each year. The hedge portfolio returns in each cell are the return difference between the top and bottom quartile portfolios. The t statistics are provided on the time-series means of 13 annual hedge portfolio returns earned on each cash component, and also on the time-series means o f 11 annual returns for years prior to 1999 for TAXBEN. ***, **, and * denote statistically significant at the 1%, 5%, and 10% levels, based on two-tailed t tests. TABLE 10 Fam a-M acB eth Cross-Sectional Regressions of Size-adjusted R eturns on C u rren t Cash Com ponents M^i=^a+fiiamm+^ACn+mONREG+JhTAmm+hm+XiRESm+AAARm+X4DUM+a^i (1) A R , ^ i ^ a + PiOTHERt + /3iACC, + XNONREC + XiTAXBENt + AiRDt + A'iRESTRt + AaARFM + A'aDUMi + a\BETAt + ai\n{M)t + ai\n{BIM)t + uaMOMi + st a \ Model 2 a Model 1 coeff. (2) t-stat ’’ coeff. t-stat INT 0.06 1.28 0.38*** 2.69 OTHER -0.38 -1.26 0.05 0.16 ACC -0.49 - 1.21 -0.18 -0.39 NONREC 0.4 0.33 2.01 1.51 TAXBEN" 8 32*** 3.55 4.88** 2.17 pre-1999 10.39*** 4.66 5.84** 2.28 1999&2000 -3.12** -2.47 -0.52 -0.41 RD -1.57** -1.96 -1.38* - 1.86 RESTR 2.11 1.62 0.84 0.37 ARFIN -0.23 -0.36 0.06 0.12 DUM -0.06 - 1.6 -0.07* -1.73 BETA 0.03 0.73 SIZE - ln(M) -0.05*** -4.64 ln(B/M) -0.002 -0.11 MOM 0.16** 2.34 “ Each model conducts annual cross-sectional regressions within a full sample of 3,238 firm-year observations, 1988-2000. ***, **, and * denote statistically significant at the 1%, 5%, and 10% levels, based on two-tailed t tests. *’ Coefficients are time-series mean o f 13 individual yearly coefficients, and t-stats are calculated as the mean coefficient divided by the standard error from the distribution of the yearly coefficients. While unreported here, Durbin-Watson statistics indicate no autocorrelation in the yearly coefficients of TAXBEN, RD and DUM. The mean coefficient on TAXBEN and cross-temporal t statistics from yearly regressions are presented for both the whole sample period (1988-2000) and the period prior to 1999 (pre-1999). The coefficients and White t stat for 1999&2000 are from OLS pooled regressions combining observations in fiscal year 1999 and 2000 together. 74 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. CD ■D O Q. C o CD Q. ■CDD C/) (/) TABLE 11 O O ■D c q ' Persistence of C u rre n t Operating Cash Components for One-Year-Ahead Earnings. Sample of 3,172 Firm-Year Observations, and t from 1988 to 2000 “ 3O’ Q E4R +i=a+/JiOCK+ /}iACG+dxxNONREC-^SixTAXBM+Sixm + ^ a xRESIR + & xARHNxDUM+S'axOJM+a+1 (3) CD ■D O Q . C a o ■o o CD Q . ■CDD C/) C/) of Coeff p-value INT OCF ACC 0.001 0.777 0.599 -0.23 (0.76) (0.00) (0.00) (0.02) RD RESTR ARFINxDUM DUM -0.68 -0.093 -0.524 -0.018 -0.008 (0.02) (0.02) (0.02) (0.74) (0.03) NONREC TAXBEN ^The coefficients on the cash component represent their difference in the earnings persistence from other operating cash flows. The OLS coefficient estimates are from the pooled regressions, and the numbers in parentheses below are two-sided p-values associated with heteroscedasticity consistent White-t statistics. Numbers in bold indicate the significance level at or below 5% level, two-sided. TABLE 12 A bnorm al R eturns Associated w ith O ne-Y ear-A head Cash News and C u rre n t O perating C ash Com ponents Panel A: Abnormal Returns to One-Year-Ahead Cash News “ ARt +1= ;ro + yiU C F t + 1+ y i U E A R t +\ + st +i Coeff. T-stat (4 ) UCFt+l UEARt+l 1.08** 2.26*** (2.23) (5.18) Panel B: Regressions o f Abnormal Returns to Future Cash News on Current Cash Components * Ak^x = a + AxNONREC, + XiTAXBEN, + XiRD, + A'jRESTR, 4- XaARFIN, + X\DUM, + s,*x 1988-2000 Coeff. Tstat 1989-2000 Coeff. T stat 1999&2000 Positive Negative (5) INT NONREC TAXBEN RD RESTR ARFIN DUM -0.003 -1.18 -0.291*** -2.62 0.633 0.64 -0.143*** -0.203 -0.96 0.193 0.94 -0.012*** -0.002 -0,76 -0.269** -2.28 1.409** -0.144** -2.37 -0.185 -0.81 0.085 0.45 -0.012** 2.08 -0.13 2 11 3 9 4 2 11 5 6 8 7 2 11 10 -2,57 -2.64 -2.47 “ The panel reports the mean coefficients and associated cross-temporal t-stat on UCF and UEAR from 13 individual yearly regressions for model (4). UEAR,+i is the residuals et+i from the OLS pooled regression for the benchmark earnings forecast model; E A R , ^ x = a + R x O C F , + ! 3 2 A C C , + e , *x UCFt+l is the estimated residuals et+i from the OLS pooled regression for the benchmark cash forecast model: C F , + i = a + j5 ix O C F , + /?2 x C A P I T A L , + x M-R.+ x M N V , + f i s x h A P , + /?6X D E P A M O , ^ P i x O A CC, + s , ^ x ***, **, and * denote statistically significant at the 1%, 5%, and 10% levels, two-tailed. *’ The mean coefficients and associated cross-temporal t-stat on each o f the cash components are separately reported for the 13 yearly regressions from 1988-2000, and 12 yearly regressions from 19892000. The row of 1999&20G0-reports the coefficient on TAXBEN estimated from OLS pooled regressions combining observations of fiscal year 1999 and 2000 together. The number of positive and negative yearly coefficients is presented below. AR, +1 is the abnormal return associated with one-year-ahead cash news, calculated as the mean coefficient yi estimated from equation (4) multiplied by the unexpected cash flows UCFt+l over year t+1. 76 R eproduced with perm ission of the copyright owner. Further reproduction prohibited without permission. [...]... ission of the copyright owner Further reproduction prohibited without permission persistence from the other operating cash flows^ and possess significant incremental value in the prediction o f cash flows in the next three years (both operating cash flows and free cash flows) Speciflcally, nonrecurring cash flows lead to relatively fewer future cash flows and they are relevant for forecasting cash flows. .. 20, 2000 Prior to the effective date, companies have choice of reporting them as part of operating cash flows or financing cash flows If the same cash effects are not classified in cash from operating activities’ but in other sections of the statement of cash flows, this study does not deem it as problematic operating cash reporting, and those firms would have zero of such operating cash components... restrictions on the components o f cash flows to have the same ability to forecast future cash flows Taking the reported cash flows at face value forsakes information contained in the components that is relevant for predicting future cash flows Several operating cash components may inform about future cash flows differently from the other operating cash flows By definition, nonrecurring cash items, ex-ante,... in the future in the same way as other routinely generated cash Operating cash flows include some investment-type expenditures such as R&D expenses that are expected to generate cash flows over multiple future periods The lack of matching between the cash costs o f the investments and their benefits can result in a different predictive ability from other periodic cash outflows The cash flow effects from. .. when the firm engages in the sale transactions, and 0 when firms do not have the financing vehicle or firms do not utilize it The coefficient on the interaction term represents the persistence difference between the cash from selling or securitizing receivables and the other cash flows, so I test the alternative hypothesis that 54< 0 against the null 84 = 0 Because discounting all future cash inflows... d others The associated cash effects o f these unusual or infrequent income components may possess less predictive ability for future cash flows than the other cash flows One example is cash from the operating income or loss o f discontinued operations If these items are really nonrecurring as claimed by companies in the financial statements, they should be irrelevant for forecasting future cash flows. ”... the reported cash from operations downward Some high-growth firms may not generate positive operating cash flows in the current period as a result o f heavy investments, however they may have tremendous cash inflows when those investments tum out to be successful The ability o f these investment-type cash expenditures to indicate future cash flows probably differs from that o f periodic operating cash. .. because they are subject to managerial discretion Nonetheless, the accounts receivables sold or financed are generated from the continuing and core operating activities Therefore, if firms engage in these transactions regularly, the cash effects could be recurring The hypothesis regarding the persistence o f these cash flows is stated in altemative form: HI (4): The cash flow effects from the sale... than other operating cash flows The second hypothesis concems the extent to which stock prices distinguish among various cash components and reflect their respective forecasting and persistence properties for future cash flows If the cash components are not priced in a manner consistent with their respective cash flow implications, as new information about future cash flows arrives or actual cash flows. .. in prior studies or the wealth transfer effects o f the stock options Additionally, the stock market fully reflects the additional information in nonrecurring cash flows This dissertation focuses on the prediction o f future cash flows, a theoretical valuation input, to test whether the stock market correctly reflects the cash flow components’ implications for future cash flows There is a body o f